The term “internalization” originally referred to the practice of filling a customer's order out of a firm's own inventory rather than sending it to the wider marketplace for price improvement. Because a firm can make money on the difference between the buying price and selling price and there is potential for abuse, this practice is generally frowned upon by regulatory bodies and investor watchdog groups.
Over time, however, the term “internalization” has broadened to such an extent that in some circles the term “internalization” includes any type of trade where a dealer participates. The types of trades involved in internalization matches are usually large block trades that are transacted off-exchange (e.g., “upstairs”) because firms feel they are better able to handle the risk involved in committing the significant capital required.
The internalization of orders has long been a controversial topic. In 2000, the SEC undertook a study of the effect of internalization on the execution quality of customer orders and invited market participants to comment on the subject. Detractors claimed that the practice harms investors by overcharging them and reduces market liquidity and transparency since the orders are never exposed to the public markets for competition. Proponents claimed that internalization actually benefits investors because it allows firms to fill their customer orders quickly before the market moves away from their exposed order price.
Some market centers claim that they prevent internalization by exposing orders to the marketplace first for price improvement. However, the period of exposure has declined significantly (e.g., from 30 seconds to 3 seconds on some markets) over the past years. Furthermore, with the increased reliance on electronic routing capabilities, firms can also find themselves in the situation where even though they did not explicitly internalize a customer order at the firm, it is nevertheless subsequently matched with another order from the firm. This can occur when the firm routes buy orders and sell orders for the same issue to the same market center for execution, even if it does not route them at the same time. Although this after-the-fact pairing does not constitute internalization per se, because the orders were not coupled prior to being routed, it can nevertheless be a concern for firms that are sensitive about avoiding even an appearance of impropriety. Since the execution quality of brokerage firms is ranked by financial services research organizations according to criteria that includes whether orders are internalized or not, some firms may choose to not trade with their own orders at all, even if the execution occurs automatically without human intervention on another market center.
Accordingly, there is a need for a method of tagging orders on a posting market center so they do not execute against contra side orders from the same firm.